15.13 Year To Claim an Interest Deduction

As a cash-basis taxpayer, you deduct interest in the year of payment except for prepayments of interest (15.14). Giving a promissory note is not considered payment. Increasing the amount of a loan by interest owed, as with insurance loans, is also not considered payment and will not support a deduction. However, an accrual-basis taxpayer generally deducts interest in the year the interest accrues (40.3).

Here is how a cash-basis taxpayer treats interest in the following situations:

On a life insurance loan, where proceeds are used for a deductible (nonpersonal) purpose, you claim a deduction in the year in which the interest is paid. You may not claim a deduction when the insurance company adds the interest to your debt. You may not deduct your payment of interest on an insurance loan after you assign the policy.

On a margin account with a broker, interest is deductible in the year in which it is paid or your account is credited after the interest has been charged. But an interest charge to your account is not payment if you do not pay it in cash or the broker has not collected dividends, interest, or security sales proceeds that may be applied against the interest due. Note that the interest deduction on margin accounts is subject to investment interest limitations (15.10).

For partial payment of a loan used for a deductible (nonpersonal) purpose, interest is deductible in the year the payment is credited against interest due. When a loan has no provision for allocating payments between principal and income, the law presumes that a partial payment is applied first to interest and then to principal, unless you agree otherwise. Where the payment is in full settlement of the debt, the payment is applied first to principal, unless you agree otherwise. Where there is an involuntary payment, such as that following a foreclosure sale of collateral, sales proceeds are applied first to principal, unless you agree to the contrary. See also 15.12 for the effect of payments on the allocation of debt proceeds.

Note renewed.

You may not deduct interest by merely giving a new note. You claim a deduction in the year the renewed note is paid. The giving of a new note or increasing the amount due is not payment. The same is true when past due interest is deducted from the proceeds of a new loan; this is not a payment of the interest.